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ONE OF THE mysteries of life in the United States today is why we are not in the midst of a raging inflation, a depressing recession, or both. The answer, though, is staring us in the face.

For the past 30 years, hard-nosed devotion to the theory of a natural rate of unemployment (a frequent target in this space) has been a prerequisite for appointment to the economics faculties of our major colleges and universities. Hence the doctrine has not only been taught at those institutions, it has been accepted respectfully in editorial rooms and enthusiastically in board rooms across the land.

The theory, of course, claims that if too few people are unemployed, inflation will accelerate rapidly, and the only way to slow it down is to raise and keep raising the interest rate. Chairman Alan Greenspan of the Federal Reserve says he does not altogether agree with the theory. He keeps talking, however, about raising the interest rate on some unspecified occasion in the future.

Yet today unemployment is lower than it has been for decades, while inflation (especially if you figure it as the Boskin Commission did a couple of years ago) has been practically invisible for at least four years. Moreover, during the same period the interest rate has been relatively stable. If mainstream economic theory were sound, the world would not move in this way.

Nevertheless, the world does move in this way and, I make bold to predict, will continue to do so until the Baby Boomers start retiring in substantial numbers, at which point the present stock market boom will come to an end. I hasten to explain that I agree with Mr. Greenspan that the market is overenthusiastic, overpriced and in danger of collapsing. But I also think that as long as the Baby Boomers keep pouring their savings into it, and as long as the interest rate does not go up, the market will continue to rise in a classic example of the “law” of supply and demand.

The situation is beautifully ironic. The market is all the bad and dangerous things Mr. Greenspan says, and he could stop them by jumping the interest rate-as the Reserve did in 1978 (not to mention 1929). But the Federal Reserve Board does not dare to act. Every three months the Reserve Board meets and the bankers anguish over their belief that inflation must be around the comer. Their terror, though, is that if they raise the interest rate to stop the inflation no one else can see, they will be remembered for having precipitated one of the great economic crashes of all time[1].

So the booming stock market that concerns Mr. Greenspan has incidentally forced the Reserve into an unnoticed experiment that lays bare the fallacies of conventional interest rate policy. If the economics profession can bring itself to pay attention to what is happening in this accidental experiment, we may be spared further exposure to the barbarous theory of a natural rate of unemployment.

Even without the experiment, the Reserve should have learned a few of the effects of raising the interest rate-at least five bad effects and one claimed to be good. The first thing it does is cause a drop in investment. By investment I don’t mean speculating in mutual stock funds and derivatives; I mean helping to finance the organization, continuation or expansion of companies that will produce goods and services to be sold in the marketplace and enjoyed by everyone. In the capitalist system, almost all investment depends directly or indirectly on credit, that is to say, borrowing.

Let’s look at the record. In the early 1960s, when the Federal funds rate averaged about 2.7 per cent, annual investment ran over 21 per cent of the gross domestic product. Today the Federal funds rate is at 5.5 per cent, and investment is only 16 per cent of GDP in an economy that, according to Mr. Greenspan’s recent Congressional testimony, is one of the best he has seen.

Second, an increase in the interest rate favors established and big businesses over small and start-up businesses. Since the latter provide most of the new jobs, any impediment to new business is an additional handicap for the poor, as well as for middle-class would-be entrepreneurs. Indeed, the percentage of American families living below the poverty line is higher in this economy that is one of the best Mr. Greenspan has seen than it was 25 years ago.

The third thing raising the interest rate does is raise the unemployment rate. According to conventional theory this cruel absurdity is a good thing and the way things are supposed to be. Howsoever that may be, the unemployment rate today is 4.5 per cent, or lower than it has been since 1969. In the quarter century before 1969, though, there were no fewer than 12 years with a lower rate of unemployment than the 4.5 per cent of this economy that is one of the best Mr. Greenspan has seen.

Fourth, raising the interest rate raises Federal, state, local, and school taxes, as the recent hoo-ha over the deficit has taught us all.

Fifth, raising the interest rate is a principal way for the rich to become richer. Mr. Greenspan has more than once cited the widening gap between the rich and the poor as dangerous to our democracy. He has protested that it is a problem for Congress, not for him. But every interest payment is a transfer to the haves from the have-nots. To be sure, not everyone who borrows is down and out. Still, as a general rule, people who lend money are richer than those who borrow[2].

The shift from 4 per cent (or lower) FHA and VA mortgages of 50 years ago to today’s “low” rate of 7 or 7.5 per cent has been a gift of billions (if not trillions) of dollars to mortgagees and a corresponding drain on mortgagers. No wonder the rate of home ownership has fallen in this economy that is one of the best Mr. Greenspan has seen.

Now, I am not saying that the interest rate is solely responsible for the rich becoming richer and the poor poorer, and I am emphatically not against borrowing and lending and the charging of interest. I am saying that interest always has the immediate effect of taking from the poor and giving to the rich; that therefore the rich are richer and the poor poorer; that increasing the interest rate increases this effect; that the present rate does not improve matters (except in relation to the rates Mr. Greenspan’s predecessors gloried in); and that an unnecessary uncertainty is introduced into the economy by Mr. Greenspan’s unwillingness to specify conditions that would prompt him to raise the rates further.

THAT’S the bad news-or some of it-about raising the interest rate. The good news-or what’s supposed to be good-is that raising the interest rate stops inflation. Well, no one can say it quite does that, because since World War II the Consumer Price Index has gone up in every year except 1955 (and that year the prime interest rate was lower than in any subsequent year) [3].

But there have been 10 surges of the economy since World War II, and except for the present surge, every one of them was seen by economists as threatening to spiral into inflation and snubbed down by the Federal Reserve Board. In short, its raising the interest rate reduced the investment rate, increased the bankruptcy rate of businesses, increased the poverty rate, increased the cost of living, raised taxes, made the rich richer, caused nine recessions-and thus slowed the rate of inflation.

Those consequences were not unpredictable. They are inherent in the nature of money, something conventional economics has archaic ideas about. Money has no price (there is no point in paying a dollar for a dollar bill). What money has is power-purchasing power and borrowing power. The piece of greenbacked paper you have in your pocket has no practical use as paper. It is an IOU of the state, was issued by the government in payment for some goods or services, and will be accepted by the government in payment of some tax or fee. It is accepted in private transactions because there are always, somewhere in the economy, citizens who need government IOUs to pay taxes or government fees.

You may borrow the use of someone else’s money by paying a fee (interest), which is a cost to you and has the effect of diminishing the amount you can borrow. The relation of money to the fee for its use is similar to the relation of the price of a government bond (also an IOU) to the rate of interest. In both cases, the higher the interest rate, the lower the purchasing power (the effect on borrowing power, essential for investment, is even more severe).

When one speaks of low purchasing power, it is the same as speaking of a high general price level. By upping the interest rate, the Federal Reserve Board reduces everyone’s purchasing power and thus increases the general price level.

Raising the interest rate does not cure inflation; it causes it. (This, you may remember, is Brockway’s Law Number Two, first proclaimed here in the issue of January 9, 1989.) Raising the interest rate gives the appearance of stopping inflation because, on the supply side, it increases the costs of operating a business, discourages expansion and leads to downsizing, which, in turn, reduces wages and thereby contracts the demand side. In other words, raising the interest rate tends to bring about a recession.

That is the way all threats of inflation have been contained since World War II -with a single exception, the present one. This time the Federal Reserve Board has refrained from raising the interest rate, as its governors would normally be inclined to.

The current stock market boom has accidentally forced upon us an economic experiment of world shaking possibilities. We are finding that holding the interest rate steady does not cause inflation, even when the unemployment rate steadily falls[4]. All the dismal prophecies of a natural rate of unemployment have proved false. Also proved false is the immoral claim that a decent minimum wage causes unemployment.

With such empirical results in hand, we may be emboldened to take the next step and discover that lowering the interest rate can lower the price level, increase productive enterprise, and start the long task of healing the suppurating wound in our society that gapes between the rich and the poor.

Do we dare?

The New Leader

[1] Ed – this experiment has been repeated during the Obama administration when the Fed under Bernanke and now Yellen kept interest rates low whilst talking on end about raising them

[2] Ed – on this fifth factor, despite low interest rates in the Obama years the separation continues. Just speculatin’, but the current economy is fully “globalized” and has no Glass-Steagall.

[3] Ed – current tables add only one other year, 2009, the deepest year of the Great Recession

There was a reason for that. The going interest rate for mortgages had reached 15.84 per cent. You may be sure there were “points” and lawyers’ fees and title insurance and surveyors’ fees and such to pay, too. As a result, the real estate market was sluggish, despite the fact that the children of the Boomer Generation were coming on line. With fewer houses sold, fewer mortgages were undertaken. Although the interest rate was out of sight, consumers had less interest to pay because not as many of them could afford it.

So the Bureau of Labor Statistics reduced mortgage interest as a factor in the CPI. This shrank the index as a whole and President Ronald Reagan got credit for controlling inflation, which President Jimmy Carter had not been able to do. Now a similar scheme is being suggested.

Federal Reserve Board Chairman Alan Greenspan, who seems to have been the scheme’s most prominent publicist, has a new and original end in view: He wants to turn the CPI into something it never was intended to be, in order to solve a problem no one thought existed.

From its beginning in 1919 the CPI, issued monthly by the Bureau of Labor Statistics, has shown the changes in what urban consumers shell out for the goods and services they buy – commonly referred to as a “market basket.” (Farmers get much of what they consume “free.”) As with any index, the items in the basket are weighted to reflect how frequently they appear on the typical shopping list. It was the “weight” of mortgage interest, for instance, that was scaled down in 1982.

Alone, an index number means nothing. You must have at least two numbers that are put together in the same way for a comparison to be possible. The CPI is a series of numbers. Similar series are created by those trying to compare the price levels of different countries and periods.

The CPI is used by historians as well as economists. And it is not discriminating. It does not try to measure the cost of what consumers ought to spend their money on; rather, it tells us what urban consumers do spend their money on. Over the long run, it needs periodic adjustments to accurately reflect the basket’s cost. In the short run, it is a measure of inflation and deflation.

Fear of inflation has been the economic neurosis of our time. Especially after World War II, it became common for contracts to contain Cost of Living Adjustments, or COLAS. The purpose was to ensure that no party to a contract either profited or lost from shifts in the price level. In 1972 and ’73 the idea was adopted for Social Security benefits. In 1986 the tax brackets in the Federal Income Tax were “indexed” to the CPI, so that taxpayers would not find themselves creeping into higher brackets even though their “real” incomes had not changed. Now COLAS appear in many kinds of contracts, public and private. Bankers also have long charged borrowers an inflation premium that is a COLA in everything but name.

What has been happening since Greenspan said last year that the CPI “overstates inflation” and should be corrected would be ludicrous if it were not liable to cause havoc in millions of lives. It seems that either the Reserve Board Chairman or someone with access to him happened to notice one day that the CPI doesn’t measure the cost of living. As we have seen, it never pretended to. Moreover, if Chairman Greenspan had time to stop and think, he would not only realize that the CPI is what is wanted in the sort of situation described above[1], but that the cost of living in a literal sense has nothing to do with it.

In sad fact, it is probable the whole mess was caused by the childish attraction almost everyone in the government and the media seems to feel for acronyms. One imagines a publicity flack being given the job of announcing a contract that provided for “an adjustment of compensation to offset, nullify, and render nugatory substantial shifts, if any, in the price level.” After much fretting and black coffee, the flack, inspired, rushes in to the director of public relations, whose door is always open. “Look, chief,” she or he cries, “let’s drop all this garbage. Let’s call it a ‘cost of living adjustment.’ Then for short we can call it a ‘cola.’ Get it?” The chief says, “Not bad.” Then he or she shows how he or she got to be chief. “We’ll run it in caps,” he or she adds softly, taking out a pad and a Mont Blanc pen and printing the word in big capitals: “C 0 L A.” The rest is history.

Possessed of the misapprehension that when people spoke of COLAS they truly meant what it cost to keep a person alive, Chairman Greenspan, though scarcely a close student of the physiological form of the problem, saw that many of the factors in the CPI were not essential costs of living. One hypothetical example seems to appeal to most of those who have taken up the idea. Think of beef, they say; everyone knows its price has gone up, but no one has to eat it, even in England. Chicken is not only cheaper, it’s better for you (less cholesterol, unless you persist in frying it); so chicken should be in the CPI basket instead of beef. That way, the cost of living would be less.

The reasoning would be impeccable if the CPI were supposed to measure the cost of living. Indeed, in that event the argument could be carried a step or two further. Bread (whole wheat or oatmeal, of course) is cheaper than chicken. Cake, as Marie Antoinette discovered, is not cheaper than bread, but rice (unhulled, of course) is. No doubt there are even cheaper ways of keeping body and soul together, but I’m not anxious to know about them. I can already hear King Lear: “0, reason not the need! Our basest beggars are in the poorest thing superfluous. Allow not nature more than nature needs: Man’s life is cheap as beast’s.”

Not even Speaker Gingrich is likely to argue openly that the cost of biological existence is all that should concern us. Nor does Chairman Greenspan, who has noted that the CPI may be overstated in part because it overlooks shoppers who switch to bargain brands and discount stores, really believe the index should tell us citizens what to eat and, afortiori, how to clothe and shelter ourselves. For my part, I do not think that there shall be no more cakes and ale, and I doubt that either the Chairman or the Speaker thinks so. The cost of living, as Lear implies, may well require a standard, but index numbers are compared with each other, not an exogenous standard.

THAT BRINGS us back to the purpose of COLAS. They are not, and never have been, intended to lift Social Security benefits up to the poverty level. They couldn’t do that at any acceptable cost if we wanted them to. In the case of union contracts, they would not be worth bothering about if poverty were the best they could guarantee. No, the COLAS were and are meant to offset the effects of inflation.

Needless to say, the CPI is not a perfect yardstick. In particular, there are serious difficulties with the way the housing component is calculated that result, as Dimitri Papadimitriou and L. Randall Wray of the Jerome Levy Economics Institute have shown, in an accelerating upward bias of the index. On the other hand, when senior citizens cozy up to the fireplace on cool evenings, they are apt to exchange anecdotes about how everything costs a great deal more than it used to.

Having said all that, let me say further that I am opposed to indexing in principle, for it is always and everywhere inflationary. In every case where, as in the Weimar Republic, a runaway inflation has occurred, indexing has been at the bottom of it.

But, as I’ve written before, “Bankers Have the Classic COLA” (NL, January 9, 1989), and as long as they have it, the rest of us are entitled to all the CPI-driven benefits we can get. With the support of economic theorists, bankers (and lenders generally) divide the interest they charge into two parts: “real interest,” which is what they would charge in a stable economy, and their COLA, or “inflation premium,” which is generally said to be the same as the year-to-year change of the CPI. At first glance this seems as reasonable as any other COLA, but it doesn’t work out that way, because the total indebtedness of the nonfinancial sectors of the economy (you, me, the corner store, and the government) is almost double the GDP.

In other words the total Bankers’ COLA, while supposedly designed to protect lenders from inflation, is about double what inflation costs the whole economy (lenders and borrowers and everyone). The arithmetic is apparently too simple for most economists to understand: In 1995, the rate of change of the CPI was 2.5 per cent; the total indebtedness was $13,804.2 billion; so the Bankers’ COLA was .025 x$13,804.2 billion, or $345.1 billion. At the same time, the GDP was $7,297.2 billion, which, when multiplied by .025, gives $182.4 billion as due to inflation. Take away the Bankers’ COLA of $345.1 billion, and the economy is in deflation, not inflation.

I am, you may be sure, aware that the 1995 CPI applies only to indebtedness incurred in 1995, which is only about a twelfth of the total. The other eleven twelfths include mortgages and Treasury bonds stretching back to 1965, though almost all debts are of more recent vintage (the average length of current public debt is less than six years). The key point is that in only one of those 30 years (1986) was the change in the CPI lower than in 1995. In short, taking 2.5 percent as the Bankers’ COLA rate for all debts outstanding in 1995 gives lenders a generous benefit of a serious doubt, particularly since it is not unknown for individual bankers to figure more than the CPI as the inflation premium.

In sum, if there were no Bankers’ COLA, there would now be no inflation, hence no occasion for all the other COLAS, hence no need for Chairman Greenspan to raise the interest rate to “fight inflation,” nor for Speaker Gingrich to weary himself dreaming up arcane tricks to play on the elderly.

Furthermore, although I am not scared silly by the present deficit, I am terrified by and ashamed of the budgeteers’ mindless and compassionless trashing of American culture and civilization. Therefore

I want to point out that if the Board Greenspan chairs devoted itself to getting rid of the Bankers’ COLA, it could lower the interest rate and put us on a fast track to a balanced budget and a more humane and more prosperous America.

The New Leader

[1] Ed – the author is not here to ask but this is the link we believe he is making here

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THE WAY WE’RE going, we’re not getting close to the truth about what happened to the savings and loans. It’s much easier to be bemused by the amount of money lost in the disaster, to be shocked by the skulduggery involved, to be flabbergasted by the bad judgment of rich men, to be titillated by political charge and countercharge.

The $500 billion fiasco has been a long time in preparation. The first official action leading up to it was taken as early as March 1951, when the Federal Reserve Board got the Treasury to agree to a slight advance in interest rates. In his Memoirs, President Harry S. Truman criticizes the Reserve for failing to live up to its part of the agreement; but as William Greider points out in Secrets of the Temple, the issue became moot with President Dwight D. Eisenhower‘s election. Wall Street won out over Washington. The Reserve has, ever since, been undisturbed in following its gleam.

When the media go beyond personalities, they explain that the S&Ls failed because they borrowed short and lent long. That is, they accepted deposits that could be withdrawn at will (30 days’ notice was often reserved but seldom enforced), and they lent against mortgages running 30 years into the future.

The curious fact, however, is that the S&Ls were deliberately set up to act in this way from their beginnings in the Great Depression. They were designed to perform two functions: First, they would offer a safe depository for the small savings of the middle class; second, they would aggregate those savings and lend them to finance middle class home ownership. Because the functions were restricted, it was understood that expenses would likewise be restricted. S&Ls, it was reasoned, could therefore offer a little bit more than the going rate on the deposits and charge a little bit less than the going rate on the mortgages. And so it was.

The new S&Ls were successful for more than 30 years. They were substantially responsible for the United States’ achieving the highest rate of home ownership in the world (a rate considerably higher than the present one). They were also substantially responsible for a rebirth of personal savings following the Depression. My wife and I were able to buy a home and start saving at a far younger age than either our parents or our children.

For all those years that they were contributing to the wealth and happiness of the American people, the S&Ls were borrowing short and lending long. Obviously, something else caused the downfall.

Plenty of people are ready to tell you the problem was inflation. Inflation is always bad for lenders. If the price level is rising at a rate of 5 per cent a year, anyone lending $100 today will receive back only $95 in purchasing power a year from now. At the same time, naturally, inflation is good for borrowers, who borrow $100 today and pay back $95 in purchasing power next year.

But look at the performance of the S&Ls over the long run-specifically, over the life of a mortgage. In that run of 20 or 30 years a go-getting middleclass American will both a borrower and a lender be. He/she will borrow at the beginning and save toward the end. They will gain from inflation (if any) when they are young and lose to inflation as they approach middle age. From their point of view, there is much to be said for this balance. From the point of view of the lending bank, inflation is not without its compensations. Inflation of real estate prices has the advantage of improving the quality of the bank’s portfolio. Foreclosures will be fewer, and losses in each foreclosure will be lower. Taken by itself, inflation no more explains the S&L debacle than does the borrowing-short-lending-long story.

Now we reach the root of the matter: What devastated the S&Ls was a tremendous rise in the interest rate.

The first noticeable sign of things to come was a period of tight money in 1955-57, but no one expected the trouble we’ve seen. The Federal Funds rate in those years jumped from 1.78 percent to 3.11 per cent, and continued to rise. By 1965 the average S&L was earning only 0.5 per cent on its capital. Crises followed in 1966, ’69, ’74, and ’78. High T-bill rates and the new money-market mutual funds drained the S&Ls of deposits.

When on October 6, 1979, the new chairman of the Federal Reserve Board, Paul A. Volcker, announced that thereafter the Reserve would concentrate on the money supply and let the interest rate go as it pleased (it pleased to go up), the S&Ls’ fate was sealed. In March 1980, the grandiloquently styled Depository Institutions Deregulatory and Money Control Act confirmed the seal. Practically unrestricted competition, coupled with $100,000 deposit insurance, guaranteed that the Savings and Loans, trying to escape the consequences of high interest, would engage in a binge of blue-sky financing and outright thievery. The only surprise is that the binge lasted for a full decade before the general collapse.

But what could the Federal Reserve do? Doesn’t inflation cause the interest rate to rise? When all is said and done, isn’t the culprit the usual suspect-inflation? It’s too bad – $500 billion too bad – that the S&Ls got caught in the crossfire of the Federal Reserve’s war with inflation, but the war must go on, mustn’t it?

Given the size of the S&L disaster, I suggest that the Reserve ought to have a pretty convincing explanation of the necessity for its actions. Chairman Volcker used to tell us that the interest rate was none of his doing but was the doing of the impersonal market. To the best of my knowledge, his successor, Alan Greenspan, has not said him nay. Well, if the Federal Reserve does not control the interest rate, I don’t know what it does do – unless, as W.S. Gilbert sang of the House of Lords, it does nothing in particular and does it very well.

Of course, the Reserve claims to control the money supply. Its Federal Open Market Committee buys or sells government bonds (it could trade in other assets as well, but prefers not to). If it wants to contract the money supply, it sells government bonds until enough banks buy enough of them to reduce their cash reserves and hence their loan-issuing power. If it wants to expand the money supply (a stratagem that rarely crosses its mind) it buys government bonds and builds up the banks’ reserves.

There’s more to buying and selling than stamping your foot and saying that’s what you want to do. Your price must be right. If you want to sell, your price must be enticingly low. A low price for a bond (or any asset) yields a high rate of return. Not only are banks eager to buy high-interest Treasury bonds, they are also quick to adjust upward the rates they charge their customers, whose credit, after all, is less solid than that of the U.S. Government. In the same way, when the Open Market Committee buys bonds at a high price, it drives the interest rate down.

Because the money supply is not a precise figure (the Reserve publishes four different major and two minor ways of measuring it), the effects of this activity on the money supply are not precise. But it certainly does have determinate effects on the interest rate, and that certainly has definite effects on the cost of living.

ALL OF WHICH brings us back to 1951. In the preceding decade the Federal Reserve Board and the Treasury worked together to maintain the price of government bonds, and the prime rate for most of those years – despite their including World War II and the first year of the Korean War remained steady (believe it or not) at 1.50 per cent. In 1951 the Reserve, worried about inflation, managed to break free of the agreement with the Treasury and thereafter devoted itself to controlling inflation by managing the money supply.

As it happens, 1951 is the midpoint between the founding of the Reserve in 1913 and 1989, the most recent full year for the Consumer Price Index. Several fat volumes would be required for an exhaustive economic history of each period, and a thorough analysis of the impact of those histories on the CPI would be beyond reasonable achievement. Yet some events are clearly more significant than others. For obvious reasons, wars are held to be especially inflationary, while depressions are deflationary. World Wars I and II and the start of the Korean War occurred in the first period, while the Korean War truce talks and the Vietnam War occurred in the second period. The recession of 1920 and the Great Depression occurred in the first period, while there have been five (or six, if you count what’s going on now) recessions in the second period. So we may say with some justice that the control of inflation should have been no harder in the more recent period particularly since the Federal Reserve Board had now proclaimed this to be its primary objective – than in the earlier one.

How, then, do the two periods compare? From 1913 to 1951, the Consumer Price Index (1982-84 = 100) rose from 9.9 to 26, an increase of 163 per cent. In the later period, from 1951 through 1989, the index rose from 26 to 124, an increase of 377 per cent. In other words, during the 38 years that the Federal Reserve

Board has been deliberately and ostentatiously fighting inflation, the inflation rate has gone up more than twice as fast as it did in the previous 38 years. On the record, the burden of proof is on the Federal Reserve Board to show that its policies, which have resulted in the destruction of the S&Ls, have been effective by any standard whatever.

As I have argued previously (“Bankers Have the Classic COLA,” NL, January 9, 1989), a high interest rate causes rather than cures inflation. This will always be true because the outstanding nonfinancial debt in the nation is greater than the GNP. At the present time, the former stands at about $9.75 trillion, and the latter is about $5.4 trillion. Thus each percentage point in the interest rate is paid for by an increase of $97 .5 billion in the general price level, while a one point increase in inflation costs only $54 billion. With interest rates currently running about six points above normal, this year’s net cost of the Federal Reserve Board’s inflationary policies will be $261 billion – or considerably more than the budget deficit everyone moans about.

In comparison, the cost of the S&L mess is small potatoes. Nevertheless, it must be added to the other costs the Federal Reserve Board is responsible for. Several Presidents and Congresses have undoubtedly acted stupidly in regard to the S&Ls, but the S&Ls would still be operating and prospering to the benefit of us all if it were not for the stubbornly misguided behavior of the Federal Reserve Board.

The New Leader

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A RECENT EDITORIAL in the New York Timesopened with these words: “Michael Milken is a convicted felon. But he is also a financial genius who transformed high-risk bonds junk bonds into a lifeline of credit for hundreds of emerging companies. Snubbed by the banks, these businesses would otherwise have shriveled …There is no condoning Mr. Milken’s criminality. But if overzealous government regulators overreact by dismantling his junk-bond legacy, they will wind up crushing the most dynamic parts of the economy.”

This reminded me of a story about Henry J. Raymond, the Times’ founding editor and a member of Congress. One day he was prowling the House floor, trying to arrange a pair on an important upcoming vote, so he could return to New York on business. Old Thad Stevens (one of my heroes) asked, “Why doesn’t the gentleman pair with himself? He’s been on both sides of the question already.” Raymond’s successors seem to be straining to be on both sides of the junk-bond question.

For my part, I’m ready to grant that Milken is (or was) a crackerjack salesman and a mighty cute operator. But a financial genius he was not. Certainly he was not the first investment banker (what an impressive-sounding job description!) to sell carloads of not-of-investment-grade securities (see “JunkBonds and Watered Stock,” NL, March 24, 1986). Nor is the New York Times the first journal to discover virtue in such super salesmanship. Nor, I daresay, is this the first time the Times itself has made such a discovery. Junk bonds are a slight variation on a very old theme, played at least as early as the Mississippi Bubble and the South Sea Bubble, both of which burst in 1720.

I’m also ready to grant that a lot of emerging companies have been snubbed by banks, yet I rather wonder why. Having paid casual attention to some banks’ advertising campaigns, I was under the impression that nothing was more likely to make a banker’s day than an opportunity to lend a helping hand to a bright but inexperienced young woman with a new idea for a flower shop, or to a similarly energetic young man eager to play a part in the great drama of American business. If the banks weren’t seizing these opportunities, what were they doing with the money they persuaded us to deposit with them?

Well, one thing they did was make Milken’s junk-bond business possible. They were no big buyers of junk bonds themselves (although the savings and loans snapped up about a tenth of those issued). Instead, they supplied bridge loans. When Robert Campeau made his deals to buy the Allied and Federated department store chains, he did not put up much cash. He counted on selling junk bonds, and he knew that would take a little while, especially since it was important to wait for the moment when the market was right. The banks loaned him the money to bridge that gap. After the bonds were sold, the banks would be paid off, handsomely.

The trouble was, it turned out that the junk couldn’t be sold, at least not at the necessary price; so the banks involved couldn’t be paid off. They were stuck with nonperforming loans, and Campeau’s stores took refuge in bankruptcy. There are recurring rumors that one of the banks is on the verge of bankruptcy, too. Junk bonds aren’t doing a job the banks are falling down on; the banks are in fact doing the job indirectly by making all those bridge loans. The banks are essential players in the junk-bond game.

Not surprisingly, the Federal Reserve Board (which is responsible for the availability of credit) doesn’t see a problem here, anyhow. The Board has just reported: “There is little evidence that a ‘credit crunch’ is developing; the majority of businesses say they have not seen any change in credit terms and have had no trouble getting credit. Where credit tightening by banks and thrift institutions has been noted, however, it has mainly affected newer small businesses and the real estate industry.” A medical researcher would scorn that diagnosis as anecdotal. It doesn’t mean much to say a “majority” of businesses have no trouble with credit; 49 per cent could be having a lot of trouble.

Whatever the situation, we can be sure that the “newer small businesses” turned away by the commercial banks are also unable to find an investment banker ready to float junk bonds for them. The junk bond market being thin and precarious, a $3 million issue is about the smallest anyone will undertake. This assumes a company with upwards of $15 million or $20 million in annual sales. It is not the sort of stuff that made Milken notorious, but it is considerably more than can be expected from most newer small businesses.

A new small business has always had a tough time and always will, for the reason suggested by John Maynard Keynes. “If human nature felt no temptation to take a chance,” he wrote, “no satisfaction (profit apart) in constructing a railway, a mine, or a farm, there might not be much investment merely as a result of cold calculation.” Every new enterprise faces a high probability of failure.

Real estate, though, is a key industry. New Building Permits Issued is one of the “leading indicators” of the economy. No prosperity lasts long if real estate does not prosper. Moreover, we have great need of it. Not only do we have uncounted millions of homeless and ill housed; we are unable, in this supposedly family-oriented society, to provide enough affordable housing for young couples, employed and upwardly mobile though both partners may be.

Still, as everyone knows, real estate loans are prominent among the troubles of savings and loans and of commercial banks like the one pushed to the brink by the Campeau fiasco. Why do the loans go bad? Not because the housing is not wanted or not needed, and only partly because prices are too high. It is the high carrying charges that are to blame. Real estate loans go bad for the same reason junk bonds go bad. The interest rates are usurious. The usury affects real estate developers (another impressive job description) and contractors as well as potential buyers, and commercial construction as well as residential. High interest rates are a main factor of high real estate prices – and of high furniture and food and clothing prices, too.

Interest charges paid by the nonfinancial sectors of the economy are now in excess of 20 per cent annually. They were only 4.9 per cent of the GNP in 1950, rising to 7.2 per cent in 1960, to 10.1 per cent in 1970, and to 15.0 percent in 1980. These great leaps forward, culminating in today’s 20 per cent, didn’t just happen. They were carefully fine-tuned by the Federal Reserve Board.

Why did the Board members do it? They have certainly told us enough times. They’ve been fighting inflation. Unfortunately, the fight has not been remarkably successful. You can see that from the fact that the Consumer Price Index, which stood at 24.1 in 1950, reached 126.1 by last December-an increase of 523 per cent in the 40 years in question. (As I’ve remarked before, this figure seems to me too low; the food, clothing, shelter, transportation, education, medicine and entertainment I buy have all increased much more than that. But let that pass.)

HIGH INTEREST becomes a self-fulfilling prophecy. What is prophesied is the probable failure of the borrowers. The probability is a risk the lenders must protect themselves from. They protect themselves by charging even higher interest. That, naturally, increases the risk of failure.

Abstractly there is no end to the escalation of interest rates, for there is no end to the escalation of risk. Indeed, in a sort of Malthusian progression, risk increases geometrically while rates increase arithmetically. Actually, of course, the escalation does have an end, because potential borrowers are driven off. That may be prudence, but foreclosing production (or consumption) does not make for prosperity.

It all comes back to the nation’s monetary policy – its rates and rules and regulations. Deregulation, combined with tightened credit, results in escalation of rates. Escalation of rates discourages production and encourages speculation. Junk bonds are just one of the forms speculation takes. Junk bonds are the creation of the nation and of the Federal Reserve Board (which is, absurdly, an independent power), not of the genius of a super salesperson.

There is another issue here. The Times thinks that junk bonds are good because they force companies to become more efficient (and hence more “competitive”) in order to payoff the high interest charges. If this tale isn’t false, I wish somebody would cite a few shining examples.

There are certainly examples on the other side, Allied and Federated department stores being first among them. Both chains were long established. I know, because in the days of my youth I spent many gold-bricking hours waiting in their sample rooms to see buyers. They were also successful. They’re not successful now.

Furthermore, the usual test of efficiency is a fat bottom line, and the quickest way to fatten the bottom line is to fire some people and put a leash on the rest. But as John Kenneth Galbraith argued years ago in The Affluent Society, an economy that makes life unpleasant for people is something we don’t need. If the virtue of junk bonds is that they are a sort of handicap inspiring efficiency, why not try a different handicap by giving all the working stiffs a raise? It used to be said that management’s first test was meeting the payroll. Why wouldn’t meeting a bigger payroll be a better test than paying higher interest?